Diseconomies of scale

Originally posted 7-24-04

While we often read about economies of scale, we probably should pay more attention to the diseconomies of scale.

When a solid sphere doubles its radius, its surface area increases 300% while its mass goes up 700%. The same ratio seems to affect organizations. As they grow, the center becomes more remote from the surface-the part that actually is in contact with customers, competitors, and new technology. The gravitational pull of the increased mass draws more and more efforts inward where they focus on internal processes, procedures, rules, expenses, and politics.

Internal forces soon overwhelm the organization's ability to respond intelligently to external events. As Jack Welch puts it, the company "has its face toward the CEO and its ass toward the customer." An odd posture to be sure since as Peter Drucker has preached for a half-century "the only profit center is a customer whose check hasn't bounced."

Costs Versus Expenses

It is counterintuitive to include expense control as one of the driver's of diseconomies of scale. How can saving money be bad?

There is a big difference between costs and expenses. Accountants, for example, rarely quantify the costs (in lost revenue) of inertia, strategic indecision, or product delay. They can easily calculate money saved using less expensive materials, but they rarely capture the erosion in brand equity which results from using inferior materials. Accountants are willing to spend time to save money even though we know that is usually better to be first to market.

If effective employment of intellectual capital is the key success factor in the new economy, then should training and education be an expense or investment? And where do most accounting departments put it?

Furthermore, most cost containment exercises are Mickey Mouse. They focus on little items like office supplies, travel, and training budgets. As such they are Band-Aids and placebos. Managers get to feel like they are doing something while big issues are ignored.

Moreover, an expense focus is a continuation of a nineteenth century mindset. It presumes that customers are grateful to have something rather than nothing. But the days are long gone when the typical customer will happily lineup for black Model T's simply because they are cheap. We have, as consumers, come to expect more choices and new products. Squeezing out expenses threatens a company's ability to compete on these other dimensions customers care about.

But what's the first lever executives reach for when trying to improve profits?

For 40 years after the end of Prohibition Schlitz was America's best-selling beer. Then they decided to change the formula so it would brew faster (i.e. cheaper). The new formula changed the beer's taste and customers deserted in droves. By 1984 nobody drank Schlitz anymore.

Notional Benefits, Real Problems

Take this everyday example of the center becoming a drag on performance.

The organization decides "leverage its buying power" to reduce costs. At the outset, everything sounds great. Centralized buying promises increased profits because costs will go down while responsiveness and quality will not change one iota. With great fanfare, a new purchasing process is put in place and new experts appointed to oversee it. But the benefits are only notional.

The purchasing staff quickly makes suppliers aware of the new decision criteria. The latter get with the program and focus on delivering low costs. Quality service and responsiveness usually suffer because they are less quantifiable than price and because the purchasing unit is too removed from the action to gauge the non-quantifiable dimensions of the product. (If they can't graph it, it doesn't exist).

Often, the central buyers become an internal police force- shoving standardization on diverse business units so that order quantities can be increased and inventories managed more efficiently. But standardization can create products that fail in the marketplace because they are neither fish nor fowl.

GM experienced this when they consolidated platforms. In theory this allows multiple divisions to utilize the same basic components with immense savings in research, engineering, and tooling. The result was the Cadillac Cimmeron-a Chevy Cavalier with minor changes and a high price. Not only did it flop in the marketplace; it inflicted grievous harm to Cadillac's image as a premium product. Even today, standardization has created look-alike models which have strong appeal to no particular segment. GM sales are lackluster. They keep losing share.

Ford faced similar dilemmas as it pursued the white whale of the "world car"-a single model that can be sold in dozens of countries in great quantities. But the Ford Escort was too bland and under-powered to sell at a profit in the US. At the same time, it was too large and expensive to be successful in Latin America and Eastern Europe.

Centralization also creates political problems. Like courtiers around the throne HQ staffs create suspicion between the center and the market frontier. They usually have influence, sometimes they are responsible for some expense lines. But they do not have responsibility for any whole project. The line managers, who do have that responsibility, have to deal with the marketplace and the central staff. No surprise, often the latter gets the most attention.

Peter Drucker has written of management's "degenerative tendency" to focus on internal and operational data, to the exclusion of the more important and more strategic information about customers, competitors, and technology. Centralization and defused authority feed this tendency and exacerbate the problems it causes.